Profit From The War On Obesity With This Left-For-Dead Stock

We are losing the battle of the bulge. Though health care practitioners have been trying to raise awareness about the perils of obesity for a decade, the numbers keep getting worse.

According to a survey conducted by Gallup-Healthways, 27.2% of all Americans are classified as obese, up a full percentage point from 2012. A stunning 32.5% of people ages 45 to 64 are considered obese. Those figures go hand in hand with rising rates of diabetes and hypertension.

Although investors had been pinning their hopes on obesity drugs offered by Vivus (Nasdaq: VVUS), Orexigen Therapeutics (Nasdaq: OREX) and Arena Pharmaceuticals (Nasdaq: ARNA), the fact that all three of those stocks still trade below $10 -- despite many years of hype -- shows that pill-based approaches have been underwhelming.

Little-known EnteroMedics (Nasdaq: ETRM) may have come up with a better approach. The company has developed an implantable device that impedes signals coming from the vagus nerve. EnteroMedics' VBLOC (vagal blocking therapy) keeps the stomach from sending the brain a message that it's time to eat.

Though the company has already received regulatory approval in Australia and Europe, it's the U.S. market that represents the holy grail for EnteroMedics, simply because the obesity rate is so high.

Shares of ETRM surged above $30 in 2009 when the company first began discussing VBLOC, but fell below $1 earlier this year when investors grew concerned that the company's promise would never be realized. Yet, in early December, the company released fresh clinical data that helped breathe new life into shares.

On the face of it, the clinical trial data figures are impressive. Fifty-four percent of the patients using the device lost at least 20% of their excess weight (the difference between their current rate and their ideal rate). That compares with just 26% for the control group. Those patients also showed improvements in blood pressure.

News of the study led Northland Capital's Suraj Kalia to boost his price target for ETRM from $3 to $7, suggesting that the company could eventually be acquired for 5 to 10 times forward sales.

Does the recent clinical data suggest VBLOC will be a huge success? The fact that patients will need to tolerate an implantable device means this approach is more onerous than just taking a pill. However, many obese people have found that pill-based therapy just doesn't work for them.

It's this group that is the best candidate for VBLOC. And VBLOC is less invasive than gastric bypass surgery or gastric banding surgery, which requires a four- to six-week post-surgical recovery process.

Analysts at Lake Street Capital Markets, who have a $3 target price, think "EnteroMedics can gain meaningful share of the 350,000 patients that undertake bariatric (weight loss) surgery worldwide each year, a comparatively more drastic and risky treatment option."

Will the FDA approve VBLOC? Investors will soon find out. The company is expected to meet with an FDA advisory panel in the first quarter of 2014, which could lead to FDA approval in the second half of 2014.

"Recent FDA inquiries have focused on post-approval issues like physician training and surveillance studies, implying that the agency is getting closer to wrapping up the application process," notes Lake Street analyst Bruce Jackson.

Still, a bit of caution is warranted. Even if the FDA approves VBLOC, it will take time for doctors to warm up to this surgical approach. It's also unclear what reimbursement schemes will look like. It's crucial that Medicaid or private insurers get behind VBLOC, and it's incumbent upon the company to make the case that this weight loss approach will reduce spending on health care in terms of other obesity-related ailments such as diabetes and hypertension.

Also, EnteroMedics ended the year with about $20 million in cash and will likely need a capital injection if it proceeds with a U.S. launch. The recent strength in its share price could lead management to pursue an equity offering in the near term, which might pressure shares.

Even with those risks in mind, the upside is huge. The company currently has 60 million shares outstanding, and even if that figure rose to 80 million through fresh share issuance, the company's market value could eventually approach $500 million, implying a price target north of $6. I'm applying a $4 price target to reflect the risk of non-approval by the FDA, a potential double from current prices.

Action to Take --> -- Buy ETRM up to $2.50 -- Set stop-loss at $1.50 -- Set initial price target at $4 for a potential 60% gain in six months